Exchange rate regimes, monetary policy and inflation targeting Gill Hammond Deputy Director, CCBS Bank of England
April 2006 Gill.Hammond @bankofengland.co.uk
Exchange rates and capital flows April 2006
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Policy issues •
Do some exchange rate regimes deliver better economic outcomes? – And is it the same for advanced and emerging market countries?
•
How are exchange rate regimes linked to global imbalances?
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Exchange rates and capital flows April 2006
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Policy issues •
How do inflation targeting countries with floating exchange rates think about the exchange rate?
•
What are the lessons for policy makers?
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Exchange rates and capital flows April 2006
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Exchange rate regimes and economic performance; conventional wisdom • Mussa (1986); real exchange rates were more variable under floating regimes • Baxter and Stockman (1998); little evidence of systematic differences in the behaviour of other macroeconomic aggregates or international trade flows under alternative exchange rate systems. • Ghosh, Gulde and Wolf (2002) ; inflation was lower and growth higher in countries with fixed ER
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Exchange rates and capital flows April 2006
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Exchange rate regimes; how much choice do policy makers have? • Bi-polar view: countries’ effective choice is between hard pegs (such as monetary unions or currency boards) or free floats (usually with inflation targeting). • Discredited theory and empirically not true
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Exchange rates and capital flows April 2006
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Number of countries as a percentage of total
All Countries: Exchange Rate Regimes, 1991 and 1999 98 (62%)
100 90 80 70 60 50 40 30 20 10 0
1991 63 (34%)
45 (24%)
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77 (42%) 36 (23%)
25 (16%)
Hard Peg
1999
Intermediate Exchange rates and capital flows April 2006
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Number of countries as a percentage of total
Developing and Emerging Market Countries: Exchange Rate Regimes, 1991 and 1999 36 (65%)
40
1991
35
1999
26 (47%)
30 25 14 (25%)
20
15 (27%)
16 (29%)
15 10
3 (5%)
5 0 Hard Peg
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Intermediate Exchange rates and capital flows April 2006
Float ©Bank of England
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Conventional wisdom has been challenged • Little correlation between reported regimes and what happens in practice; • Flexible currencies exhibited fear of floating (Calvo and Reinhart 2002) • Fixed rates moved o/a devaluations or dual/parallel markets • Correlation only held 50% of time (Reinhart Rogoff 2004) • Only 20% of de jure free floats actually floated • About half of “managed floats” had de facto pegs, bands or anchor currency • 45% of unofficial pegs “floated” Gill.Hammond @bankofengland.co.uk
Exchange rates and capital flows April 2006
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Why “floaters” might not move much – Stable macroeconomic position – Desire for ER stability but with flexibility to respond to shocks – Avoid speculative attacks
• Fear of floating – – – –
Concern about pass-through Financial vulnerabilities/currency mismatch Competitiveness Nominal anchor for inflation expectations
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Exchange rates and capital flows April 2006
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De facto exchange rate studies • De Facto classifications; – Gulge, Ghosht, Wolf – IMF – Levy-Yeyati and Sturzenegger
• New results on relationship between exchange rate regime and growth, inflation – Reinhart and Rogoff (2004) • “no support for the popular bipolar view” • Intermediate regimes alive and well Gill.Hammond @bankofengland.co.uk
Exchange rates and capital flows April 2006
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Exchange rates and capital flows April 2006
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Source: Rogoff et. al. (2004) The Bank of England does not accept any liability for misleading or inaccurate information or omissions in the information provided.
Gill.Hammond @bankofengland.co.uk Source: Rogoff et. al. (2004)Exchange rates and capital flows
April 2006
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Exchange rate regimes and global imbalances • Hybrid international monetary system; some systemically important countries float while others fix or manage exchange rates • Could lead to asymmetric shocks if imbalances unwind
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Exchange rates and capital flows April 2006
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Exchange rate regimes and global imbalances • Are imbalances result of decentralised savings/investment decisions? • Or do national economic policies contribute? – US current account deficit; partly funded by build up of FX reserves in Asian central banks
• Oil prices have added to imbalances
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Exchange rates and capital flows April 2006
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Bank of England survey • Research workshop at CCBS. Experts from 28 countries plus IMF,BIS • survey of 94 central banks • 3 month research project ; which monetary frameworks
have delivered best inflation results? “Monetary Policy Frameworks in a global context” Mahadeva and Sterne, ed (2000) Gill.Hammond @bankofengland.co.uk
Exchange rates and capital flows April 2006
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Number of Countries with particular combination of explicit targets
Use of Explicit Targets in the 1990s 90
Inflation
No explicit target
80 70
Money & Inflation
60
Money
50 40
Exchange Rate, Money & Inflation Exchange Rate & Inflation
30
Exchange Rate and Money
20
Exchange Rate
10 0 1990
91
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92
93
94
Exchange rates and capital flows April 2006
95
96
97
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98
Implications for policy • Low inflation (below 3.8%) associated with stable inflation • Traditionally, stable inflation achieved in Germany, US, Japan and countries that pegged to these currencies. Later, under inflation targeting regimes. • BoE survey did not find examples of developing countries achieving low stable inflation except thro fixed ER. Gill.Hammond @bankofengland.co.uk
Exchange rates and capital flows April 2006
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Recently low inflation achieved by emerging markets with floating ER and inflation targeting in emerging markets, “IT appears to have been associated with lower inflation, lower inflation expectations and lower inflation volatility relative to countries that have not adopted it” IMF WEO Aug 2005
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Exchange rates and capital flows April 2006
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Inflation targeting • Institutional commitment to price stability as main goal of monetary policy • Public announcement of quantitative target for inflation over specified horizon • Official interest rate is main policy instrument • Floating exchange rate
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Exchange rates and capital flows April 2006
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Inflation Targeters; Start Dates and Initial Inflation 45
Peru 40
35
Inflation Rate (%)
30
Chile
25
20
Israel
Mexico
15
Ghana Colombia
Czech Republic
10
Poland
Canada 5
New Zealand 0 1989
Korea
UK Sweden
Brazil Australia
1990
1991
1992
1993
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1994
1995
1996
South Africa 1997
Indonesia
Hungary
1998
1999
Exchange rates and capital flows April 2006
2000
Romania Turkey
Iceland Philippines Norway Thailand 2001
2002
2003
2004
Slovakia 2005
2006
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2007
Exchange rates and inflation targeting • Some EM central banks initially adopted IT in conjunction with ER target (eg Hungary, Chile, Israel) • Problem of 1 instrument and 2 targets usually resolved either by trade off, or use of sterilised intervention in FX market as second instrument. (Though strong doubts about effectiveness when there are open capital markets) Gill.Hammond @bankofengland.co.uk
Exchange rates and capital flows April 2006
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Exchange rates and inflation targeting • Problem in clarity • Policy conflicts undermine credibility of targets; benefits of anchoring inflation expectations are not realised • …Most countries gradually abandoned ER targets.
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Exchange rates and capital flows April 2006
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Inflation targeting and floating exchange rates • Inflation targeters do not ignore exchange rate; • ER channel important transmission mechanism for monetary policy – directly (traded goods prices, and therefore CPI) – indirectly (via wealth and income, and aggregate demand) – indirectly (via balance sheets and credit channels)
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Exchange rates and capital flows April 2006
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Forecasting exchange rates • No shortage of models:Dornbusch (1976); Equilibrium approach; New Open Economy macroeconomic (NOEM) models; microstructural approach • But they don’t fit the data. And forecasting performance is poor; Mees and Rogoff (1983) found they were no better than a random walk
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Exchange rates and capital flows April 2006
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Forecasting exchange rates • • •
Key part of inflation targeting framework is inflation forecast Exchange rate assumption/forecast is important input The exchange rate is hard to predict:
“I have no idea where exchange rates will go in the future and I have no intention of ever starting to forecast exchange rates. That’s a mug’s game” (Mervyn King) Gill.Hammond @bankofengland.co.uk
Exchange rates and capital flows April 2006
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Exchange rates and inflation forecast • Unconditional forecast; interest rate path and exchange rate path are endogenous • Conditional forecast; uses technical assumptions for exchange rates (also interest rates) • Both have advantages and disadvantages Gill.Hammond @bankofengland.co.uk
Exchange rates and capital flows April 2006
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Alternative exchange rate projections
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Exchange rates and capital flows April 2006
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Lessons for central banks • •
• •
Empirical studies on exchange rate regime and economic performance not conclusive. Strong monetary framework (eg inflation targeting) more important than exchange rate regime per se Need to minimise risk of disruptive market adjustments to global financial imbalances Good communication important
Gill.Hammond @bankofengland.co.uk
Exchange rates and capital flows April 2006
©Bank of England
The Bank of England does not accept any liability for misleading or inaccurate information or omissions in the information provided.
Exchange rates regimes and monetary policy Gill Hammond Deputy Director, CCBS Bank of England
April 2006 Gill.Hammond @bankofengland.co.uk
Exchange rates and capital flows April 2006
©Bank of England
The Bank of England does not accept any liability for misleading or inaccurate information or omissions in the information provided.
